Considering Divorce? Beware of Retirement Account Breakups

Divorce can look a bit different for older couples. They generally don’t need to worry about child support or custody of young children. But splitting the retirement assets they jointly own and those that each spouse owns separately are another matter.

Along with the marital home, retirement accounts are often an older couple’s largest asset in a divorce proceeding. When both spouses have retirement accounts, the combined balances should be considered along with all other assets, says Laura Medigovich, certified financial planner and senior financial planner at Janney Montgomery Scott LLC in Purchase, N.Y.

The rules for splitting retirement assets differ depending on the type of account—IRA, 401(k) or a pension—and can be complicated. And transferring retirement funds to a former spouse can have unintended tax consequences if done incorrectly, so the stakes are high for getting it right. For one thing, you need a qualified domestic relations order (QDRO) to transfer a 401(k) account or pension rights in a divorce, but few divorcing couples may know this. The order, which is issued by a court or state agency, recognizes a divorcing spouse’s right to receive all or a portion of the account owner’s defined contribution plan or pension.

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There are two ways to divide plan assets using a QDRO. The first awards a separate interest in the account balance. The second allows a divorcing spouse to share in the payment of the benefits. Once both parties agree to the terms, the account owner gives the document to the plan administrator. Because drafting a QDRO can be expensive, Medigovich recommends that you have your divorce attorney ask the plan administrator to provide model QDRO language.

“Compared to splitting a pension, a 401(k) is a far easier asset to split,” Medigovich says. That’s because you know the account value. If one spouse has a 401(k) worth $200,000, the divorcing couple could agree in the QDRO to split the account equally. In that case, $100,000 of the 401(k) balance can be transferred directly to the other spouse’s IRA without incurring any federal income taxes or penalties. That changes, however, if the spouse receiving the money pockets the $100,000 instead of having it transferred to an IRA. Then he or she will owe income tax on the money, but there’s no 10% penalty for early distributions, even if the spouse taking the cash isn’t yet 59½. If the $100,000 is transferred to the spouse’s IRA and that person takes an early withdrawal, then the money is subject to both income tax and the 10% penalty.

Pensions are even more complicated to divvy up. Not only does each employer have different rules for how or whether a pension can be split, but you’ll also have to hire an actuary to calculate the present value of the future benefits. It’s easier to split a pension when the pensioner spouse has already started receiving benefits. Then you could use a QDRO to split the payments by either a dollar or percentage amount.

QDROs don’t apply to IRAs. To divide an IRA between spouses, the terms must be specified in the divorce or legal separation agreement, which the account owner gives to the IRA sponsor. For the money to be split free of taxes and penalties, the agreement should specify that a percentage or dollar amount of the account owner’s IRA balance should go to a spouse’s IRA in a direct trustee-to-trustee transfer. If the receiving spouse takes cash out in the transfer, he or she will owe taxes on that withdrawal and, if younger than 59½, a 10% penalty, too. Similarly, an account owner who takes a distribution from the IRA to give to a spouse in a divorce will be taxed on the payout (and owe a 10% penalty if under age 59½).

If possible, use a Roth IRA for a spouse who wants cash. A Roth is more tax efficient because withdrawals are generally tax-free.